Venture capital is the window to the innovation economy, but investment is increasingly centralised, with a handful of funds accounting for the bulk of investment, a panel of experts said at the Fiduciary Investors Symposium at Stanford University.

Venture capital also represents an investment opportunity outside the highs and lows of the market, they told delegates.

“Innovation happens all the time, no matter what markets are doing,” said Todd Ruppert, Chair of the INSEAD Endowment and venture partner Greenspring Associates. “Today is a golden era in venture capital.”

The panel observed the sharp drop in initial public offerings.

“More companies are staying private longer, with a profound impact on capital markets,” Ruppert said. He said that unicorns – privately held start-ups valued at more than $1 billion – were named such because they were rare; however, that’s no longer the case. He noted that the rise of unicorns has attracted the private equity industry to venture capital since 2008, and observed the sharp growth in the amount of dry power, or committed capital, sitting in the coffers of private equity and venture capital funds.

“This is great news for venture capital,” he said.

The panel also observed another trend – the number of financing rounds in venture capital is falling. While more money is being invested, there are fewer financing rounds, meaning fewer investors capture opportunities in the sector.

Ruppert noted that venture-backed companies have an important impact on GDP and society.

“Having some money invested in the venture-cap space makes sense,” he told delegates.

Technological innovation has made it possible for great companies to be set up from anywhere, Octopus Ventures chief executive Alliott Cole said. The emergence of cloud technologies and new infrastructure on which companies can lay applications such as PayPal and Dropbox have taken away the complexity of setting up a business.

“The cost and complexity of establishing a business is zero,” Cole said. It is now possible to set up and launch a product, and generate revenue, before an entrepreneur invests in capital expenditure and infrastructure. This is game-changing, he said. Moreover, social media allows start-ups to access millions of potential customers in targeted and efficient ways across the globe.

Cole also commented on how the distribution and open sourcing of know-how and knowledge is helping build new businesses.

“Venture capital used to be opaque and entrepreneurs didn’t know how to access funding,” he said. “Now all that knowledge is open-sourced and shared, and it is possible to understand the building blocks that create a large and successful enterprise.”

Start-ups do still face challenges. None more so than co-founders ending up “doing everything”, Atomic general partner Chester Ng said. He said founders should concentrate on building and selling, and not chasing engineers or trying to do everything but mastering nothing.

Key venture-capital opportunities exist in the technologies transforming financial services, said Mark Smith, chief executive and co-founder of blockchain developer Symbiont.io. He referred to a “ramp up” in the ability to change the way financial markets are structured and said investors should embrace the opportunity. Innovations would include companies becoming incorporated in new ways using blockchain technology, he predicted. He also said new technology would help tap liquidity in private companies.

“New infrastructure will begin to open up that liquidity in peer-to-peer interaction,” Smith said. Going public might be very different in the future, with technology allowing companies to source liquidity in different areas and avoid regulation, he explained.

The panel also talked about innovation springing up outside Silicon Valley and noted that coding schools and engineering talent were now commonplace in cities like Denver and New York. Moreover, big-tech M&A activity is leading to companies putting down global roots, such as Google DeepMind’s London base. Cloud technology makes it easier to run remote teams and tapping expertise outside Silicon Valley makes start-ups safer from the likes of Google or Facebook poaching their expertise.

Venture firms now “think carefully about establishing a significant base” in Silicon Valley, Cole said, opening the door to venture funds investing across the globe.

Denmark’s largest commercial pension fund, PFA, has more than €67 billion ($77 billion) in assets under management and dates back over 100 years. It has also been a leading institutional investor in listed markets for many years. In 2016, it took a large step in terms of revamping the entire strategy within alternatives – private equity, credit and infrastructure markets.

When we introduced the new approach, the allocation was only 2 per cent and the portfolio consisted mainly of older fund commitments and a few direct investments. We wanted to increase the allocation substantially and to achieve that we knew we had to turn the traditional model upside-down and go much more direct. We also saw massive potential to leverage PFA’s independence, scale and relationships in deal origination.

Today, two-and-a-half years later, PFA’s team within alternative investments has grown from two to 15 professionals. In the beginning, people were hired for the front office but, more recently, competencies have also been added to asset management and middle-office functions. We have put together a strong team of direct investment professionals with backgrounds in investment banking, leveraged finance and infrastructure investing. They bring origination, execution and leadership skills, which is exactly what we need to succeed.

Deals are in the wind

Recent investments include the public takeover, announced earlier this year, of TDC, the Danish incumbent telecommunications provider, in one of the largest leveraged buyout transactions in Europe in more than 10 years. PFA teamed up with Macquarie and Danish pension funds ATP and PKA, with a view that attractive core telecommunications infrastructure assets existed within TDC. A full split of the company into a network entity and a customer-serving entity is now under way, which will be complemented with heavy investments into nationwide fibre and 5G networks, to be operated on a non-discriminatory, open-access basis.

The TDC transaction has clear benefits for our customers and society at large. The same story applies to our recent large renewable energy investments, which bring low-risk, fixed income-like returns while supporting the green-energy transition. In November 2017, we announced that PFA would acquire a 25 per cent ownership stake in Walney Extension Offshore Wind Farm from Ørsted. Located in the Irish Sea, Walney Extension is the world’s largest offshore wind farm. It is located in the Irish Sea and has a total capacity of 659 megawatts – capable of powering almost 600,000 UK homes with green energy.

In September, Walney Extension was officially inaugurated; later that month, we announced another landmark offshore wind transaction: Hornsea 1 Offshore Wind Farm. Hornsea 1 is under construction in the North Sea and will be the world’s largest offshore wind farm, with a capacity of 1218MW, when fully commissioned in 2020. This time, we are the sole provider of mezzanine-debt financing, backing Global Infrastructure Partners’ acquisition from Ørsted of a 50 per cent stake in the windfarm.

 

Flexible decision-making

We have a strong relationship with Ørsted and with Global Infrastructure Partners. Hornsea 1 perfectly illustrates our strategy of teaming with world-class partners within their respective fields. We have an efficient decision-making process; we can write big tickets when the right deal is on the table and we are a flexible capital provider able to work across the capital structure. This time, all of the ingredients were there to look into the mezzanine tranche.

Being able to work across the capital structure sounds easy but you need to consider carefully your origination strategy, team composition and investment processes to succeed. It requires a closely knit team with complementary skills, and you need to be firm about what ingredients a deal must have, depending on where you are in the capital structure. The last thing you want is to end up facing equity-style risks while earning debt-like returns. We have a number of internal funds we can put to work with different risk appetites. As a result, we are able to work across the risk and maturity spectrum but we have a natural preference for longer-term, lower-risk investments.

Since 2016, PFA has deployed almost €4 billion ($4.6 billion) into direct private equity, private credit and infrastructure investments in Europe and North America. These investments have been complemented by selected fund commitments with an aim of pursuing certain strategies and further developing strong relationships with leading sponsors. PFA expects to deploy roughly €2 billion ($2.3 billion) annually into direct investments and co-investments over the coming years.

It is a strategy we simplistically characterise as “more of the same”.

 

Peter Tind Larsen is head of alternative investments at PFA.

 

After the fallout at the recent Salzburg summit of European leaders, the pressure is on to make progress in Brexit negotiations before the next meeting of leaders on October 18.

Although there is hardly ever a true final deadline in EU negotiations, there is a consensus that the talks need to be wrapped up by November this year to get the deal officially approved by March 2019. Meanwhile, UK Prime Minister Theresa May must walk a tightrope to make further concessions to the EU while appeasing the pro-Brexit Conservative Party base. This means the odds of a ‘no deal Brexit’ – in which the UK would depart the EU without any formal withdrawal arrangement in place – are increasing. What could this mean for the world of pensions?

The exact impact of a chaotic Brexit on GDP growth, currency fluctuations and interest rates is anyone’s guess, but most official estimates predict depressed economic activity. This could put defined-benefit funds in a tough spot.

Falling markets could push down their assets, while central banks would shy away from tightening monetary policy, meaning liabilities might continue to be high or rise further. In countries like the UK, the Netherlands and Denmark, funds have hedged about half of their liabilities, by some estimates, meaning they are at least partly protected; however, it’s impossible to shield beneficiaries from a deep recession completely. Particularly concerned should be funds whose sponsor operates on both sides of the channel and relies on EU regulation for market access. These funds should, therefore, get to grips with the wider impact of Brexit on their sponsor and potentially the sponsor covenant.

 

Cross-border bother

While banks, asset managers and insurers would struggle with market access issues, pension funds mostly operate within national borders.

This means that the vast majority of funds could continue to operate normally and there would not be big changes to pension fund regulation. The UK is implementing the new European framework Institutions for Occupational Retirement Provision II (IORP II) through a few modest amendments to national law. These rules will continue to apply after March 2019.

There are no reams of detailed executive law or guidelines that need to become part of UK law, as is the case in other areas. After Brexit, the UK will have more flexibility in reshaping pension law but the question is whether there will be the desire to do so, given the current light-touch approach of IOPR II.

The small group of schemes that are operating across borders would be significantly affected. A few dozen of these schemes exist, many of which sit between the UK and Ireland. Without a deal, these cross-border schemes would need to fall back on domestic law to be authorised. A protocol needs to be put in place for how these schemes will operate after Brexit. Otherwise, sponsoring companies may need to set up separate schemes on both sides of borders.

 

Service providers will be affected

While a no-deal Brexit would not affect schemes’ relations with their sponsors and members, they may need to review how their service providers are affected. Free movement of capital will continue, as it applies to non-EU nationals, but not the freedom to provide services or freedom of establishment.

Asset managers, banks and insurers rely on the EU ‘passport’ to provide their services in other EU member states. With a hard Brexit, these passports would be gone. EU pension funds often use London-based providers of financial services and critical financial infrastructure, such as clearing. The UK could apply to be recognised as an equivalent third country in most cases, meaning that the EU would allow access because British regulation would be an exact copy of EU regulation, at least at first; however, equivalence decisions can be taken and revoked unilaterally by the European Commission at any point. Such decisions are unlikely to be in place by March 2019 in the case of a disorderly Brexit and could be used as a bargaining chip.

The ‘Chequers’ plan that May proposed is meant put this system on a more stable footing but the EU has not yet shown interest. As a result, many financial institutions have been setting up new subsidiaries on either side of the channel.

Continental pension schemes, in particular, should check whether their fund managers and banks can continue to serve them, whatever happens over the next months. On the other hand, a large share of investment funds is domiciled in Ireland and Luxembourg, so UK schemes should be watchful about whether they can continue accessing those under the UK’s post-Brexit national placement rules.Re-domiciling funds could crystallise capital gains, with tax implications.

 

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Derivatives

With long-dated contracts that can span decades and exposures that run into the hundreds of billions, both the bilateral and cleared derivative markets should be a particular source of concern for EU pension funds that deal with UK-based banks.

The contracts themselves would not cease to exist in case of a no-deal Brexit but, in July, the Bank of England warned that without changes to legislation, about a quarter of bilateral contracts between EU and UK parties could potentially no longer be serviced. Replacing or transferring these contracts could be extremely cumbersome and expensive. However, interest-rate swaps are an essential part of liability hedging in some countries so not replacing contracts could lead to funds’ funding ratios becoming more exposed.

Pension funds mostly deal bilaterally with banks but in the future will need to clear their transactions via central counterparties (CCP), with both regulation and market liquidity pushing in that direction. LCH.Clearnet, in London, clears 95 per cent of the overall over-the-counter interest-rate swap market. Those funds that already clear would need to assess whether these contracts would still be serviced. The EU is considering regulation that would require ‘systemic’ CCPs to be established within the EU in order to clear contracts of EU clients. Were that to happen, LCH.Clearnet would no longer be able to serve EU-based clients and would need to move a large part of its operation to the continent. Although mandatory central clearing for pension funds is still a few years down the line, funds may face a more fragmented financial infrastructure, particularly if the EU and UK do not overcome their differences over the next few months.

 

Matti Leppälä is secretary-general and chief executive of PensionsEurope.

China is one of the most innovative and technologically advanced countries in the world, charging ahead in key areas such as automation, artificial intelligence, fintech, and electric vehicles, all backed by huge government investment.

“Innovation is one of the key drivers going forward for China and it is an investible theme,” said Vivian Lin Thurston, partner and China generalist at William Blair, and founder and chair of the Chinese Finance Association.

China is leapfrogging the US and other Western countries in mobile payments and social networking, she said.

Speaking at the Fiduciary Investors Symposium at Stanford University, Thurston said China was also pushing the development of its semi-conductor industry, which has been singled out for government support and investment to reduce China’s dependency on imports. China accounts for 60 per cent of the global demand for semi-conductors, she said.

China has the largest population of Millennials in the world. It is this group that is driving consumption of new technologies, delegates heard. Thurston also noted opportunities in healthcare, one of China’s most unpenetrated industries, as the population ages.

The panel discussed how China’s A-shares market is attractive, liquid and has a low correlation with the rest of world. It is also inefficient, offering opportunities for active investors. Jeff Shen, managing director, head of emerging markets and co-head of scientific active equity at BlackRock, said the inclusion of China A-shares in the MSCI market indices was a landmark change that warranted attention, and noted BlackRock’s enthusiasm for active management opportunities in China going forward.

China will be the undisputed global leader in AI by 2030, said Winston Wenyan Ma, chief executive of China Silk Road investment and development. He said Chinese tech companies were investing more than ever before in technology and putting more focus on new technologies. Up until now, most of their focus has been on developing the consumer-side of their businesses. He also said companies sought products that were invented in China, not just made in China.

“It doesn’t mean that Made in China goes” but, like Silicon Valley, China will become a hub of smart technology companies and unicorns, he explained. China also has a consumer market to test its technology products.

“The investment landscape is shifting,” Wenyan Ma said.

China’s A-shares market is characterised by millions of retail investors driving volume – 85 per cent of trading value comes from retail investors. Watching this retail sentiment is a key tenet of success and can be done by searching online trends and blogs, Shen said. Moreover, it is possible to spot trends and opportunity through satellite imagery, picking up construction sites and economic activity in China’s 160 cities. In a typical investment model, you think of macro trends and fundamentals, Shen said. Now it is possible to search online for factors driving sentiment.

 

Access and insights

Accessing the growth in China’s A-shares market is not straightforward. Mostly because China is “complicated” and investors don’t understand it, Thurston said. Along with being dominated by retail investors, China’s A-shares index is populated by state-owned industries (SOEs), which are less efficient and have poor governance and lower returns. It is why investors should favour active investment because passive strategies would lead to exposure to these laggards, Thurston said. In another trend, the panel highlighted opportunities from investing in foreign companies with a strong Chinese footprint, such as consumer goods groups. Risk factors include regulation, Thurston noted.

The panel also noted that because the market is so dynamic, there are many losers and winners. In a dynamic marketplace, just because you have exposure doesn’t mean you necessarily have a return. The conference also heard how centralised political control and censorship made for a different kind of innovation than what occurs in Silicon Valley.

Shen said it was important to understand that China is “not trying to become the US” but is looking for its own unique solutions. Political decisions are made that prioritise keeping the vast population happy and the Communist party in power. China’s mindset is to solve problems with one political system, so although it will take inputs from the US, it has a different approach, delegates heard.

Wenyanma noted that the government was supporting innovation at a local level and via tax reductions. The government often reimbursed losses if an investment went badly, he said. In contrast, Silicon Valley is supported by venture-capital money. Thurston called China’s model a hybrid of capitalism with one-party government. She described the Chinese Government as the senior management team of China Inc, allocating capital and managing society.

“Western people don’t understand this,” she said.

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Investors have an important role in ensuring that advances in technology are managed from a human rights perspective, particularly workers’ rights. A panel of experts chaired by Fiona Reynolds, managing director of the Principles for Responsible Investment heard how there is little democracy in many workplaces, including the tech industry, many workers are on short-term contracts with little job security and few rights, and technology is making their positions even more precarious.

Investors have the influence to change things, said Deborah Ng, director strategy and risk and head of responsible investment, at Ontario Teachers’ Pension Plan. About 60 per cent of OTPP’s assets are invested in private markets, where investments are often direct, allowing direct access and communication with management. She told delegates that human capital issues are “top of the mind” and that the pension fund took care to understand how companies in its portfolio were managing human capital issues. She also said human capital management was important for driving the success of a business, since poorly engaged staff or high injury rates would damage long-term performance.

OTPP ensures investee companies have board oversight of human rights issues with a dedicated committee. Ng said if the pension fund has invested in a company in a disruptive sector, it asks that managing the potential impact on human capital be a part of strategy. She said it also checked to see that policies were enforced and requested the data and metrics to prove it.

“If we don’t see these, we know there is an issue,” she said.

Data needs to move away from disclosure and more to discovery and investors need to take more control over what they are discovering, rather than just relying on what the data is telling them, said Andrew Parry, head of sustainable investing at Hermes Investment Management. Parry also told delegates that the ‘S’ for social, in ESG, is often overlooked and pointed to the interconnected nature of many of the disruptions under way from climate change, technology and demographics. He said disruption would be significant across every industry and urged investors to focus their engagement activities on improving the quality of jobs. This can be done by putting pressure on employers to pay a living wage, and ensuring human rights throughout supply chains, particularly in the extractive industries.

Parry also told delegates that small islands of wealth and large areas of inequality were not good for long-term demand. He said this would ultimately create a fragility in long-term demand that would hurt companies’ ability to sell their products. It is about ensuring there are people left to buy products in the future, he said. He also noted that technology is changing the nature of work and demand and will impose decisions on society.

The investment community is increasingly shaped by a sense of purpose, Parry said. There is more focus on the purpose of a company and the purpose of shareholders, a trend he attributed to the vacuum at the centre of policymaking. He said investors needed to encourage an environment where technology worked alongside human capital and that society and the environment should be put at the heart of businesses.

The panel discussed how decarbonisation would lead to significant job losses and affect whole communities and towns built around traditional energy sectors.

“Don’t forget the human side,” Reynolds said. “It is not just about stranded assets, people and communities get stranded as well.”

Orderly transitions

Ng said investors needed an orderly transition to new energy sources. She said that not acting on rising physical risks would lead to reactive policies that could hurt society and returns. She said investors needed to work with policymakers to encourage the establishment of clear, long-term policies. She added that initiatives such as Canada’s Just Transition Task Force was helping address this. The plan, which includes working with people on the ground most affected by transition, is looking at how Canada can manage its resource endowment sustainably and transition away.

“Investors can work with companies to ensure they are prepared,” Ng said. “It is within our fiduciary duty to ask companies for hard plans about their future.”

The panel noted that although investors are not responsible for solving all problems, they have an important role to play in a just transition. They can engage with companies, particularly around tax and fair wages, Reynolds said. Parry said investors could also use the SDGs as a framework for action.

Autonomous cars, water assets, artificial intelligence and robotics, ageing Western populations, blockchain and Millennials prioritising purpose-driven lives all share one thing in common: they are some of the latest megatrends smart investors are beginning to access, said Claus Kjeldsen, chief executive of the Copenhagen Institute for Futures Studies and Gertjan van der Geer, fund manager at Switzerland’s Pictet. Investing for the long-term requires disregarding the benchmark and identifying the themes that will have an impact on the future, they told delegates at the Fiduciary Investors Symposium at Stanford University.

Megatrends are not an exact science and are best described as a series of observations of factors pulling in the same direction to change society. They have a lifespan of 10-15 years, are found within paths of change that are already happening; they are particularly reflected in social change. They aren’t linear; they can speed up and slow down and are interconnected. Patterns that look like megatrends can quickly dry up, said Kjeldsen, who currently highlights 14 global megatrends – or changes that “we can’t hide from”.

Interconnected megatrends can take time to finally overlap. For example, electric cars need a transformation of the grid, which is still a way off, to facilitate growth. Kjeldsen told delegates to identify enablers and blockers to see which megatrends would take off and counted regulation as a potential blocker. Uber’s uptake in Europe has been affected by types of regulation, he said. He highlighted how interconnecting opportunities could also spin off megatrends; for example, he explained how the growth in electric cars would make traffic more efficient, leading to wider pavement and the need for fewer parking spaces in cities. In another example, he said developments in blockchain technology would change how we view trust.

Investing in megatrends involves a large universe, said van der Geer, who runs 15 megatrend strategies. He also said investment involved a long period of underperformance that could run for 10 years and advised delegates to “stop looking” at the benchmark and instead find companies where “the market disagrees with you”.

He said success involved identifying where markets mispriced long-term opportunities on the way up and down.

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